‘Schrödinger’s Economy’
Headed into Q3 reporting season in the US, the narrative among many top-down strategists sounded a lot like it did prior to Q2 earnings.
A "reckoning" was imminent. There's only so long profits can hold up in the face of gale-force margin headwinds from elevated raw materials costs to soaring wage bills to higher interest rates. At the same time, the consumer was destined to retrench, as generationally high inflation and economic uncertainly reflected in lackluster sentiment finally manifested
All to say, inflation isn’t going away any time soon. I could see it abate to the 4-5% range for 3-9 months (higher YoY comps, supply chain fixing, etc) before coming back again driven by various US Treasury interventions (Fed will still be in “saving face” mode) to stem the liquidity issues in the global bond markets and a rebound in equities (possible bull market) in early 2023.
When it comes back, that’s when things get “really interesting”.
Should have pulled the trigger on that call option yesterday 🙁
Two call options actually, just so the algos “know” I’m not retail :smirk:
A possible scenario is economy and earnings stronger for longer, inflation higher for longer, Fed tighter for longer, and this continues until something breaks.
We could continue with this pattern of bear rallies and pullbacks, lower highs and lower lows.
Even if economic indicators and earnings are not going down as fast as the most bearish expect, they are still going down,
Index levels and investor actions have not yet reached capitulation levels. I know sentiment has been ugly, but how much actual panic have you seen?
Inflation is not slowing meaningfully. Lags and stickiness (labor, wage, shelter, etc) suggest accelerated slowing might not show up until 2023, possibly mid-year.
Absent evident impending or actual breakage, the Fed may be loath to call time on tightening when inflation hasn’t shown signs of easing.
My working theory is a 4Q rally (3900? 4100?) then new lows.
With so many short term options in play, I expect VIX to get more expensive relative to historical volatility. This leaves the index drifting intra-day in annoyingly tight bounds for a couple of months.
I’ve been trying to take a personal budget based way of thinking about inflation. Thirty to thirty-five percent of an average person’s expenditures, give or take, are spent on shelter. Once raised, rents will not go lower for folks already renting. Other costs of shelter like heat, light, power and taxes are also going to to remain sticky for now and the foreseeable future. Home prices themselves may start to flow, but higher rates will keep monthly payments rising for a good while. On a cash basis those of us lucky enough to own our homes will still see rising utilities, taxes and maintenance expenses, although the house itself is not a cash drain. So, for most people, shelter-based inflation is mostly sticky and that’s at least a third of the budget for most folks. Food makes up 10-15% of the budget for most folks. I think food will keep rising for now, faster than housing, but it will not be as sticky. Clothing has also been rising and is labor intensive. The more of this we bring onshore, the harder it will be to get prices down. Clothing outlays vary, but for families with kids, it will not be easy to manage in the short-run. Medical care, while not a huge cost for many, is also a cost for all of us who are aging. This cost is rising and will not fall, probably ever. Transportation is a combination expense. This has made up less of the budget for those working from home since Covid because of fewer miles driven but insurance is up, gas is up, and cars won’t get cheaper on average as they become more complex. The conclusion I come to, on a back-of-the-envelope analysis is that for most normal, average folks, 65-70% of our budgets are going to remain locked in to items that are super sticky and interest rates aren’t going to change that prospect any time soon. People can change the quarter of their spending that is more discretionary but they will have trouble actually doing it. Perhaps the rise in prices can be brought back to 2 or 3% in five years, but by the time we get there we will be able to see the pain.
Great post.